7 Small-Cap Stocks Primed to Take Off

Small-company stocks saw a big jump after the election, with those in the value camp leading the way. Will the trend last?

Jeff John and Miles Lewis are cautiously upbeat. Co-managers of the
American Century Small Cap Value
fund (ticker: ASVIX), they believe there’s reason to be optimistic that the new administration will be good for small-cap stocks.

On average, small companies usually pay higher taxes and tend to focus their business within the U.S., which means they would see a disproportionate benefit from lower corporate-tax rates, higher infrastructure spending, and less regulation, without the worries that multinationals have about trade barriers and a stronger dollar.

Manager’s Bio

Name:

Jeff John

Age:

47

Title:

Co-Portfolio Manager

Education:

B.S. in business administration, University of Colorado in Boulder; M.B.A., Vanderbilt University’s Owen Graduate School of Management

Hobbies:

Kansas City Royals, skiing, travel, reading

Manager’s Bio

Name:

Miles Lewis

Age:

38

Title:

Co-Portfolio Manager

Education:

B.A. in business administration, College of William and Mary; M.B.A., Cornell University’s Johnson Graduate School of Management

Hobbies:

Scuba diving, surfing, stand-up paddle boarding

The big postelection rally makes finding bargains harder, but they still see opportunities in areas like financials and technology that haven’t been overbought, especially companies with strong balance sheets, high free cash flow, and solid management teams.

John and Lewis have certainly earned their value-investor bona fides: Their fund, which invests in companies with a market value of roughly $200 million to $4 billion, earns a five-star rating from Morningstar and has outperformed its peers and the benchmark Russell 2000 index for the past one, three, five, 10, and 15 years. (It’s also beaten the Standard & Poor’s 500 index for every one of those periods save for the five-year, which it trails slightly.) The fund charges annual expenses of 1.26%.

Read more about their picks from their interview with Barrons.com below.

Barrons.com: Investors couldn’t get enough of small-cap stocks after the election. How do you see the current environment for them?

John: Small-cap companies are very domestic in their nature, so they are a beneficiary of potential increased challenges facing global companies, whether it be through immigration or regulation. They tend to be domestically located and generally high taxpayers, and theoretically would be beneficiaries of a lower corporate tax regime.

More From Barron’s

Since the election, there’s been about $11 billion in positive flows into small-cap exchange-traded funds, with about $3.2 billion of that going into small value, and as they say, “A rising tide lifts all boats.” What’s interesting is the vast majority, if not all, of that rally occurred in the first month after the election, and it has been a period of digestion since that point.

Lewis: Small-caps on average pay about a 500 basis points [five percentage points] higher tax rate than large-caps. To the extent that infrastructure spending is pushed through, that’s most likely going to benefit U.S.-centric companies, which are going to be U.S. small-caps. If lower taxes and less regulation and infrastructure spending result in U.S. GDP growth, then, again, this is going to disproportionately benefit U.S.-centric companies like small-caps.

Q: Let’s talk about your bullish thesis on banks.

John: A lot of small banks are unduly stressed by both the time and the dollars associated with the regulatory oversight they have running their day-to-day businesses, so there is the belief that a lessened regulatory environment would result in them having to spend less.

Lewis: Rising interest rates and a steepening yield curve, which we’ve seen since the election, are very beneficial to the net-interest margins of banks, and that’s something that’s felt real time. Unlike infrastructure spending or lower tax rates -- hopefully, that should benefit all these U.S. companies in six, 12, 18, 24 months -- a steepening yield curve benefits the banks almost immediately. Lower regulation can’t be understated. Taxes are a big one for U.S. banks, because most U.S. regional banks have very little, if any, exposure to any overseas revenues. They are full taxpayers. And if growth picks up, then loan growth would accelerate and that would drive outsized returns to a lot of these banks.

Fund Facts

(as of Feb. 14, 2017)

American Century Small Cap Value

(ASVIX)

Assets:

$1.6 billion

Expense Ratio:

1.26%

Front Load:

None

Annual Portfolio Turnover:

95%

Yield:

0.58%

Source: Morningstar

As for specific banks,
Capital Bank Financial
(CBF) is a relatively new regional bank...with operations in North Carolina, Tennessee, South Carolina, [Florida and Virginia]. It was formed by a group of ex-
Bank of America
(BAC) bankers. It’s got a great management team. They are very conservative, they are very operationally focused, they know their customer and geography as well, and also, they own a lot of stock. That means that their interests are very well aligned with ours. It has a lot of excess capital -- this fortress balance sheet that they’ve used to buy troubled banks and then fix them up. Finally, they are going to realize the benefits of higher interest rates more than most because they are asset-sensitive, meaning that their assets will reprice faster than their liabilities or their deposits.

Lewis: Oil doesn’t fit our process and our philosophy very well, but as prices kept going down we began to worry about the performance of our fund when oil prices recovered. We didn’t want to buy lower-quality names, so we got exposure by buying diversified industrial companies that had oil-market exposure, and through Texas banks.

The Texas banking market is arguably the best in the U.S. The banks there give very good returns, and a lot of them have great market share. Texans like to bank with local banks, not national franchises, and the group has historically traded at a premium. But many of them have exposure to energy lending, and what happened was the classic baby getting thrown out with the bathwater. Texas Capital at one point lost $1 billion of market cap relative to, I think, $400 million of energy loans. So we bought a lot of Texas banks, including Texas Capital, Legacy Texas, and
First Financial Bankshares
(FFIN), which might be the highest-quality bank in the U.S. These banks put a bunch of money aside for future losses, which, to date, have largely not materialized -- which means that they have a lot of earning power trapped on their balance sheet.

Q:Are there any energy names that fit your criteria?

John:Dril-Quip
(DRQ) [which makes equipment for offshore drilling] has a really strong net cash balance sheet and generates a lot of cash. When we want exposure to that space, we like companies like Dril-Quip that, with all their businesses under pressure, still generate positive free cash flow and are adding free cash flow to a net cash balance sheet.

Top 10 Holdings

(as of Dec. 31, 2016)

Capital Bank Financial

(CBF)

Graphic Packaging Holding

(GPK)

Bank of the Ozarks

(OZRK)

Allied World Assurance

(AWH)

Multi Packaging Solutions International

(MPSX)

Hanover Insurance Group

(THG)

BankUnited

(BKU)

Entravision Communications

(EVC)

Kite Realty Group Trust

(KRG)

Legacy Texas Financial Group

(LTXB)

Source: Morningstar

Q:What else have you been buying recently?

John: We added
Rexnord
(RXN) in December. It’s an industrial manufacturer with two lines of business. One is process and motion control, basically gears, drives, chains, and bearings that run a conveyor belt, whether that’s a conveyor belt in a
Coca-Cola
bottling plant or in a copper mine. Because of its exposure to mining and energy, the business has been under pressure. The other piece of their business is water management, high-efficiency water solutions -- for example, Zurn, the automatic flush system at the back of a toilet at any sort of nonresidential building.

The nonresidential construction side of the recovery has been slower since the financial crisis, but Rexnord is a good business, good returns, great brand recognition. Fifty percent of their profits in motion control comes from replacement parts, so there is a lot of maintenance and repair components that keep it chugging along during tough times.

This stock was up 20% immediately postelection because it is going to be a beneficiary of nonresidential construction growth. Right after that, the company announced a preferred equity offering and the common stock sold off aggressively. We not only bought some of the preferred equity -- the mandatory convertible preferred stock, which gives a little bit of a yield and a little protection on the downside, given its place in the capital structure -- but we bought the common stock as well.

Q:How about a tech name from the portfolio?

Lewis: We’ve added to
Exar
(EXAR) since the election. It’s an analog semiconductor company, with about 25,000 customers. Their chips regulate power in devices -- for example, when you swipe your credit card at a store -- and allow different electronics to communicate. They are seeing pretty significant gross-margin expansion, and within semiconductors, expanding gross margins are the holy grail. They are spending their gross margins in two ways: by dramatically improving their cost structure as they take manufacturing and testing from higher-cost locations to Asia, and by introducing new products that are substantially higher than their corporate average gross margins. Now they’re introducing products that have 65%-70% gross margins, relative to the corporate average in the low 50s.

They sell to lots of different people, and typically those are kind of Tier 2 and Tier 3 providers of anything, whether it is an industrial piece of equipment or a computer server. They’re starting to get recognized by Tier 1 vendors such as
Hewlett Packard
(HPQ) and smartphone vendors. They are on the cusp, then, of a meaningful ramp in revenue. Exar has a phenomenal balance sheet, with nearly $4.50 a share of net cash, or roughly 40% of their market value in cash. They have another $4.50 of net operating losses, basically tax credits that will allow them to pay virtually no taxes for many years. There’s been a considerable amount of consolidation in the semiconductor space, and Exar would be a pretty digestible acquisition target.

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